What Are Exchange-Traded Notes (ETNs)?

Unlike ETFs, the underlying investments (bonds, commodities, what have you) in exchange-traded notes are not necessarily owned by the issuer of the ETN.

Although they sound alike, exchange-traded notes (ETNs) and exchange-traded funds (ETFs) are hugely different. ETNs, which trade just like ETFs or individuals stocks, are debt instruments. The issuer, a company such as Direxion or PowerShares or Barclays (all big players in the ETN game), issues an ETN and promises shareholders a rate of return based on the performance of X.

What is X? It could be the price of a commodity, or the value of a certain currency, or the return on a certain bond portfolio.

ETNs have been proliferating of late, with dozens having popped up in the past couple of years. Of these, only three are based on any simple and recognizable index of bonds.

All the other bond ETNs, currently 37, give you exposure to bonds in a strange, distorted fashion, typically offering you either a doubling or tripling of the bonds’ returns or, conversely, the inverse of the bonds’ performance. For instance, if Treasuries lose 3 percent tomorrow, some ETNs will go up 3 percent in value. Others may go up 6 percent . . . or 9 percent.

Although bond ETNs have one big advantage over ETFs (they are generally taxed more gingerly), they really are not very good vehicles for bond exposure. These are debt instruments. As such, when you buy an ETN issued by, say, PowerShares, you take on double credit risk.

You need to worry about the credit worthiness of those who issue the bonds in the portfolio, as well as the credit worthiness of PowerShares itself. This is not the case with ETFs.

More troubling is the nature of the beast itself. Yes, a leveraged ETN may double or triple your money — but read the fine print! The doubling or tripling is done on a daily basis. The strange mathematics of daily returns means that you will lose money over the long run. Your principal will simply be eaten away by the extreme volatility.

Take out your calculator. Imagine you hold a triple-the-daily-return ETN, such as the Direxion Daily 10-year Treasury Bull 3X Shares ETN (TYD). Imagine that you invest $1,000. Now, assume that Treasuries go up 3 percent today, 3 percent tomorrow, and 3 percent on the next day. And then assume that Treasuries go down 3 percent a day for each of the next three days.

If you were holding real Treasuries, how much would you now have? You’d have $997.30.

And what would you have in your Direxion ETN, which just went up 9 percent for three days running, and then lost 9 percent a day for three days? You’d have $975.90. After a few more weeks or months of super-volatility, you’d have far less. Extreme volatility eats returns.